Thoughts on the Crisis of Capitalism

George Soros' "The Crisis of Global Capitalism..." was published back in late-1998,
following a dreadful period of global instability. Such concerns for the most
part dissipated over the years with the resuscitation of global market and
economic booms. The market value of global debt, equities and commodities
skyrocketed. Bigger booms and busts followed and, not surprisingly, global
Capitalism is today under only more intense fire.

Strangely enough, there remains a fine line between a "crisis of global Capitalism" and
utter euphoria in the financial markets. The ECB's $620bn first round Long-Term
Refinancing Operation (LTRO) - along with expectations for an even more grandiose
3-year lending facility (LTRO II) next month - has the markets abuzz. Crisis
resolved? The unleashing of another global reflationary backdrop on which
to capitalize?

Participants certainly appreciate that the Federal Reserve has a hankering
for QE3; the Bank of England (BOE) appears poised for unending quantitative
easing; the Bank of Japan continues to flood its system with liquidity; the
Chinese will likely soon resume stimulus measures; and "developing" central
banks around the world have moved to combat a weakening global backdrop with
their own brand of monetary largess. Especially after global risk markets
have ushered in 2012 in robust fashion, the optimists and speculators can
be excused for believing that all the crisis chatter might yet again signal "liquidity
abundance, government backstops and spectacular market booms ahead."

Prime Minister David Cameron yesterday provided his take on Capitalism in
what has become a fascinating political debate in the UK. Here at home, the
outcome of the November election could very well be decided by which of two
opposing visions of a capitalistic economy best resonates with a divided populace.
These are critical times.

The Financial Times this week ran several interesting essays in their "Crisis
in Capitalism" series. Today from former ECB and Bundesbank economist Otmar
Issing: "Too Big to Fail Undermines the Free Market Faith... The crisis has
provided strong arguments for opponents of the financial system. Interventions
to avoid its collapse have severely undermined not only confidence in financial
markets but also in the market economy as a whole. Once a financial institution
has become so big or interconnected that its insolvency threatens the stability
of the system, politicians must intervene. The problem of 'too big to fail'
has made society - more precisely, the taxpayer - hostage to the survival
of individual financial institutions. As a result, the basis of free markets
has been shaken. A market economy rests on the principle that individuals
are free to act within boundaries set by a legal system... The rules of the
game should be clear. Those who succeed are free to take the profits (after
taxation); those who make losses have to bear the consequences, with bankruptcy
the ultimate sanction. Thus, 'too big to fail' not only undermines a fundamental
principle of market economies but also a principle of societies in which individuals
are responsible for their actions."

Also today, from Mohamed El-Erian: "The Crisis Raises Legitimate Questions
About Capitalism Itself... The majority of writers agree that the crisis in
capitalism is caused by two distinct failures: the inability of the system
to deliver sustained prosperity through economic growth and jobs; and the
perception that it is grossly unfair and socially unjust. ...To fail on both
counts, and to do so in such a spectacular manner, is indeed a 'crisis.' It
raises legitimate questions about the model itself. There are three main reasons
for this. Firstly, capitalism has always, and will always be, prone to traditional
market failures. The answer is to accept this, and work harder at reducing
the chances of a catastrophic failure... Secondly, during the past decade,
in another part of the world, a set of countries embarked on their own capitalist
economic revolution... Lastly, too many of the institutions that are critical
for the smooth functioning of capitalism utterly failed to deliver when they
were needed most... Each of these areas can be corrected. Theoretically at
least, what has occurred is less a calamity of the system as a whole, and
more an issue of how it was run."

Perhaps it's only semantics, but while Mr. El-Erian writes "what has occurred
is less a calamity of the system as a whole, and more an issue of how it was
run," I would instead focus on how it is "BEING run." And when Mr. Issing
writes, "The problem of 'too big to fail' has made society... hostage to the
survival of individual financial institutions," I would focus these days somewhat
less on "institutions" and more on "global debt and securities markets." I
know many analysts are of the view that system fragilities are being addressed
through greater bank capital cushions and more stringent regulation. This
is fighting the last war. I believe that a profoundly greater risk to global
Capitalism goes largely unappreciated and unaddressed.

Larry Summers this week on CBNC repeated a common view: Capitalism is inherently
flawed, but it still beats the alternative. Longtime readers know I take exception
with the view that Capitalism is "flawed." One could similarly contend that
the eyeball is flawed - that it is much too soft and fragile for having such
a vital function. In reality, it is the nature of its operation and functionality
that dictates its vulnerable structure. So it is incumbent upon those of us
relying on eyeballs to guard against potential dangers, such as excessive
sunlight (sunglasses), metal shavings (safety glasses) and disease (regular
self-assessment and trips to the optometrist when things begin to appear out
of whack).

There is certainly no doubt that Capitalism has vulnerabilities. Much less
obvious is that its greatest vulnerability lies with the nature of Credit.
This reality goes unappreciated by most - and largely undiscussed by the few
conversant in the formidable nuances of Credit analysis. Ignoring the inherent
instability of Credit is akin to staring at the lovely sun. Ironically, those
that seem to best appreciate the nature of Credit instabilities - along with
the risk posed to Capitalism - also tend to be those working keenly to extract
the greatest amount of financial wealth from grossly distorted financial markets.
Indeed, profiting from the consequences of two decades of policy measures
in response to market instabilities has engendered one of history's greatest
periods of wealth accumulation (much of it through the transfer of wealth).
And as the scope of policy prescriptions and market interventions turns only
more incredible, the whirlwind of speculation seeking market riches becomes
more intensive than ever. The markets ebb and flow and convulse, while the
Crisis of Capitalism drifts nearer to the abyss.

I am convinced that a capitalistic system must have a monetary anchor to be
sustainable. A functioning market pricing mechanism is fundamental to resource
allocation, saving and investment, wealth creation and, in the end, social
stability and cohesion. Stable money and Credit is a prerequisite. One can
also think in terms of two distinct pricing systems. There is the pricing
of goods and services throughout the "economic sphere." There is, as well,
the pricing of finance/Credit/risk in the "financial sphere." It is the pricing
mechanism within the financial sphere that has become so badly out of whack
to the point of posing dire risk to global Capitalism.

As I've noted in the past, we live in period unique in financial history:
There is globally no limits placed on the quantity or quality of Credit creation.
There is no gold standard; no Bretton Woods monetary regime; nor even an ad-hoc "dollar
standard" working to regulate global Credit expansion. Markets for pricing
finance and risk have turned progressively distorted and, in the end, dysfunctional.
This was a predictable outcome for a global "system" bereft of a monetary
anchor. Policymakers have repeatedly responded to dysfunction and inevitable
booms-turned-bust with unprecedented market intervention. This continues to
only exacerbate financial market pricing distortions and attendant imbalances.
What began as tinkering has regressed to the point of policymakers attempting
to take virtual command over the pricing of finance. Capitalism now hangs
in the balance.

I am prepared to defend Capitalism until my dying days. I expect this endeavor
to be no less of a challenge than it's been the past 12 years trying to explain
the great dangers associated with a runaway Credit Bubble. Over the long-term,
for Capitalism to succeed in the real economy requires a functioning pricing
mechanism and sound Credit system. Distorting the price of finance ensures
speculative Bubbles, the misallocation of real and financial resources, and
resulting economic maladjustment. In this regard, policymakers have bordered
on gross negligence.

Massive fiscal and monetary stimulus, along with unprecedented market interventions,
has completely overwhelmed the capacity of the markets to effectively price
risk. Instead of learning from past mistakes, policymakers are more determined
than ever to dictate market pricing. Rather than recognizing the prevailing
role "activist" central banking has played in fomenting dysfunctional markets,
policymakers believe market outcomes beckon for only greater activism. Until
governments can begin to extricate themselves from the manipulation of interest
rates and risk market pricing more generally, this long cycle of destructive
booms and busts will run unabated.

Mr. El-Erian posited that "capitalism has always, and will always be, prone
to traditional market failures. The answer is to accept this, and work harder
at reducing the chances of a catastrophic failure." Well, what lies at the
heart of these "traditional market failures"? I have a very difficult time
with the notion of accepting market proclivities and correcting institutional
failings when there is scant evidence that policymakers or the economic community
appreciate the inherent instabilities of Credit or the dangers of unsound
finance. Would less debt, leverage, government market intervention and market
speculation reduce the risk of catastrophic failure? Why then the incessant
inflationist solutions of massive deficit spending, interest-rate manipulation,
central bank monetization and progressive government control over the markets
and real economies?

Mr. Issing states that "the rules of the game should be clear. Those who succeed
are free to take the profits...; those who make losses have to bear the consequences,
with bankruptcy the ultimate sanction." Yet the overarching problem today
is that the global government finance Bubble has inflated past the point of
being too big to fail. And the rules of the game have become dangerously clear:
policymakers will do any and everything to sustain a global Credit system
some years ago exposed as dysfunctional and a risk to Capitalism. Governments
are conspicuously against the bearing of consequences, and market participants
are being heavily incentivized to play it that way.

Global central bank "international reserve assets" (excluding gold) - as tallied
by Bloomberg - were up $940bn y-o-y, or 10.2% to $10.185 TN. Over two years,
reserves were $2.364 TN higher, for 30% growth.

Total Money Fund assets declined $12.6bn to $2.692 TN. Money Fund assets were
down $70bn over the past year, or 2.5%.

Total Commercial Paper outstanding rose $5.0bn to $968bn. CP was up $51bn
from one year ago, or 5.5%.

Global Credit Watch:

January 19 - Financial Times (Sam Jones): "Greek negotiators may be about
to reach a final agreement with creditors on the country's huge debt burden
but, as with the original bonds, any deal may not be worth the paper it is
written on. Fraught discussions on Wednesday - led on the creditor side by
veteran technocrats Jean Lemierre, special adviser to the chairman of BNP
Paribas, and Charles Dallara, managing director of the Institute for International
Finance - have hit on a formula with Greek officials that an untested minority
of bondholders could yet reject. Several hedge fund managers that hold Greek
debt have said they have not been involved in the talks and will not be agreeing
with the 'private sector involvement' (PSI) deal - which centres on a 50%
loss on bondholders' capital and a reduction in the interest they receive.
Alongside them are insurance companies, fund managers and pension funds that
also have little incentive in agreeing to the negotiated terms."

January 18 - Financial Times (David Oakley and Robin Wigglesworth): "Portugal
is trading in default territory after investors offloaded the country's bonds
this week amid rising fears of contagion, hurting a government debt auction
on Wednesday. Worries are mounting that the private sector and Greece will
fail to agree a restructuring package for Athens' debt. Portuguese 10-year
bond yields... jumped to a new euro-era high of 14.40%... Wednesday. Before
the S&P two-notch downgrade late on Friday, yields were trading at 12.45%."

January 20 - Bloomberg (Paul Dobson, Emma Charlton and Lucy Meakin): "European
Central Bank President Mario Draghi's unlimited three-year loans to euro-region
banks may give Italy and Spain only temporary respite from the region's debt
crisis... The gain on the short end of the market outpaced longer-dated debt
on concern the nations' austerity plans won't plug deficits and reduce Europe's
largest debt load... 'This is about buying time,' said John Davies, a fixed-income
strategist at WestLB AG in London. 'It's only when the market believes Italy
and Spain have returned to sustainable debt levels that you can say the crisis
has truly ended.'"

January 20 - Financial Times (Patrick Jenkins and Camilla Hall): "Italy's
banks, led by UniCredit, were the biggest users of the special three-year
funding mechanism launched by the European Central Bank in December, according
to a new research report. UniCredit - Italy's biggest bank by assets - took €12.5bn
of three-year money under the facility, closely followed by Intesa Sanpaolo,
with €12bn, and Monte dei Paschi di Siena, which took €10bn, the
report from analysts at Morgan Stanley says. The data, submitted to Morgan
Stanley but not previously disclosed, underline just how reliant banks in
some eurozone nations have become on emergency mechanisms put in place by
the European authorities. It will also stoke the gratitude of the Italian
financial system towards Mario Draghi, who took over as president of the ECB
in November, instituting the funding mechanism soon afterwards. Banks across
the eurozone periphery have been frozen out of commercial funding markets
for months, as investors have shied away from anything other than the most
trusted bond issuers."

January 20 - Wall Street Journal (Sara Schaefer Munoz, David Enrich and Laura
Stevens): "Just six months after issuing billions of euros of new stock to
investors and raising hopes the European banking sector was on the mend, three
big lenders in key euro-zone economies have been hit by a fresh wave of problems.
Germany's Commerzbank AG and Italy's Banca Monte dei Paschi di Siena SpA are
scrambling to come up with billions of euros in new capital to comply with
European regulations. That is raising the prospect that they might need to
go back to their beleaguered investors--or taxpayers--for fresh rounds of
aid. Spain's Bankia SA, meanwhile, is facing a possible merger with a stronger
rival as part of the government's plan to deep-clean its banking sector, just
six months after the bank raised some EUR3 billion ($3.9bn) in an initial
public offering that was widely hailed as a success for the Spanish sector.
The travails of the three banks, coming so soon after they tapped the markets
for capital, are likely to make investors even more reluctant to put money
into cash-strapped European lenders, analysts and investors say."

January 18 - Bloomberg (Paul Dobson): "The European Central Bank and domestic
Italian and Spanish investors may need to buy as much as 121 billion euros
($154bn) of debt this year as international investors curb holdings, Barclays
Plc said. 'The behavior of foreign investors will likely remain key to the
performance of the Spanish and Italian bond markets,' Laurent Fransolet, head
of fixed-income strategy at Barclays Capital in London, wrote..."

January 19 - Bloomberg (Angeline Benoit): "Fitch Ratings Managing Director
Edward Parker said he has 'doubts' over whether Spain can reach its deficit
targets for 2012 and next year after overshooting its projected shortfall
last year. Spain's 2011 deficit of about 8% of gross domestic product 'casts
many more doubts about its capacity to hit budget targets for this year and
in 2013 and bring the budget deficit down to a sustainable level,' Parker
said... He reiterated that Fitch would likely cut by one or two levels by
the end of this month the six euro nations it put on review in December."

January 19 - Financial Times (Robin Wigglesworth, Mary Watkins and Nicole
Bullock): "The new year has brought a torrent of European bond sales, as companies
and banks race to take advantage of a window of opportunity opened by the
European Central Bank. The ECB's Christmas tonic, in the form of €489bn
of cheap, three-year bank funding - so-called LTROs - has lifted the spirits
of investors, who have grown more receptive to European bank debt. In addition
to a rush in sales of covered bonds, a type of debt considered ultra-safe
by investors, European banks have already issued €16bn of senior unsecured
euro debt this January, more than for the whole of the second half of 2011,
according to Dealogic."

January 20 - Bloomberg (Simone Meier): "Marc Faber, publisher of the Gloom,
Boom and Doom report, said it would make sense for the euro region's 'weak'
member states to leave the currency union. 'It would be good if weak countries
were kicked out or left the currency union," Faber said... 'It would be the
better solution than denial.'"

Global Bubble Watch:

January 18 - Bloomberg (Simon Kennedy): "The International Monetary Fund is
proposing a $1 trillion expansion of its lending resources to insulate the
global economy against any worsening of Europe's debt crisis, according to
an official at a Group of 20 nation. The Washington-based lender is pushing
China, Brazil, Russia, India, Japan and oil-exporting nations to be the top
contributors... The fund wants the agreement struck at the Feb. 25-26 meeting
of G-20 finance ministers and central bankers in Mexico City, the official
said.

January 17 - Bloomberg (Daniel Kruger): "For the first time, Wall Street's
biggest bond-trading firms hold more U.S. Treasuries than corporate securities,
signaling concern the economy's rebound will be too slow to sustain record
demand for riskier assets. The 21 primary dealers that trade directly with
the Federal Reserve held a total of $74.7 billion of Treasuries as of Dec.
28, compared with $61.1 billion of company debt... The aggregate position
in U.S. government bonds has increased from a $38.6 billion bet against the
securities in May, while corporate holdings have tumbled 50 percent from $121.8
billion."

Currency Watch:

The dollar index this week dropped 1.7% (unchanged y-t-d). On the upside,
the Mexican peso increased 3.2%, the Swedish krona 3.1%, the South African
rand 2.2%, the Norwegian krone 2.1%, the Danish krone 2.0%, the euro 2.0%,
the Swiss franc 1.9%, the Brazilian real 1.8%, the British pound 1.7%, the
Singapore dollar 1.6%, the Australian dollar 1.6%, the New Zealand dollar
1.5%, the South Korean won 1.3%, the Canadian dollar 1.0%, and the Taiwanese
dollar 1.0%. On the downside, the Japanese yen declined 1.0%.

January 20 - Bloomberg): "A Chinese purchasing managers' index signaled manufacturing
may contract for a third month as a slowing economy boosts the case for the
government to further loosen credit controls. The preliminary January reading
of 48.8... compares with a final 48.7 number for December."

January 18 - Bloomberg: "China's December home prices posted their worst performance
last year, with only two of the 70 cities tracked posting gains... Prices
in 52 of 70 cities monitored by the government declined from the previous
month... New home prices in the nation's four major cities of Shanghai, Beijing,
Shenzhen and Guangzhou declined for a third month, it said."

January 19 - Bloomberg: "China's biggest developers slowed home sales toward
the end of 2011, bracing for the worst property market in three years as the
government vows to keep real-estate curbs. Contract sales, or sales booked
before apartments are completed, dropped 30% last month at China Vanke Co.,
as the country's biggest developer..."

Japan Watch:

January 20 - Bloomberg (Toru Fujioka and Masahiro Hidaka): "The Bank of Japan
will maintain its zero interest-rate policy until at least 2016 as Europe's
debt crisis weighs on an economy struggling to overcome deflation, bond market
options show."

Asian Bubble Watch:

January 20 - Bloomberg (Chinmei Sung): "Taiwan's export orders fell in December
for the first time since 2009 and industrial output shrank as demand from
China and Japan declined."

Latin America Watch:

January 20 - Bloomberg (Gabrielle Coppola): "Brazilian companies from power
generator Cia Energetica de Minas Gerais to Cia. de Saneamento Basico do Estado
de Sao Paulo are leading a 60% jump in local market bond issuance as benchmark
borrowing costs tumble."

January 19 - Bloomberg (Jose Enrique Arrioja): "Mexico's unemployment rate
was 4.51% in December compared with 4.97% in November..."

Unbalanced Global Economy Watch:

January 20 - Bloomberg (Nichola Saminather): "A year ago, when Sydney property
agent Peter Green's clients decided to sell, half opted for auctions betting
competition among buyers would deliver them the best price. Today, less than
one in five take that chance. 'The vendors don't want to embark on the potential
of failure,' said Green... principal at... Laing+Simmons in Miranda, a suburb...16
miles south of Sydney's center. 'In the last three months, the number of people
visiting open houses has been cut by half. And buyers may show up to auctions,
but they don't bid.'"

Central Banking Watch:

January 19 - Bloomberg (Jana Randow): "European Central Bank Governing Council
member Jens Weidmann said policy makers should resist pressure to increase
government bond purchases in response to the euro region's debt crisis. Some
are demanding that the ECB turn to the 'bazooka' or 'nuclear option' of 'engaging
in unlimited government bond purchases and limiting yields,' Weidmann, who
heads Germany's Bundesbank, said... 'There are a number of legal, economic
and political reasons why we shouldn't do this,' he said. Such an approach
would violate European Union law, take away the incentive for governments
to implement fiscal reforms and redistribute losses within the currency union,
Weidmann said."

U.S. Bubble Economy Watch:

January 17 - Bloomberg (Leslie Patton and Lauren Coleman-Lochner): "Supermarkets
that had been adding Starbucks Corp. cafes and olive bars to draw wealthy
shoppers are now catering to a different audience: food-stamp recipients.
Stores are moving their opening hours, adding products and revamping merchandise
assortments as persistent joblessness pushes more shoppers to government support
in buying groceries. Distributions from the federal Supplemental Nutrition
Assistance Program rose 11% to a record $71.8 billion in fiscal 2011..."

Fiscal Watch:

January 19 - Bloomberg (Charles R. Babcock and Frank Bass): "Almost 15,000
federal retirees, including former leaders of Congress, a university president
and a banker, are receiving six-figure pensions from a system that faces a
$674.2 billion shortfall. About one of every 125 retired federal civilian
workers collects more than $100,000 in benefits annually... 'We don't want
to bash federal employees,' said Jim Kessler, vice president for policy at
Third Way... 'Still, when you have today's economy, public sector jobs look
better and better. And there are some pensions that make you question the
system as a whole.'"

California Watch:

January 19 - Bloomberg (James Nash and Michael B. Marois): "California's future
hinges on spending billions of dollars to link its cities with bullet trains
and to bolster its water supply, Governor Jerry Brown said, even as it confronts
a $9.2 billion deficit. The largest U.S. state by population is 'on the mend'
after years of fiscal distress and needs the projects to keep growing, Brown
told lawmakers..."